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Cost of Capital is the rate that must be earned in order to satisfy the required rate of return of the firm's investors. It can also be defined as the rate of return on investments at which the price of a firm's equity share will remain unchanged.

 

Each type of capital used by the firm (debt, preference shares and equity) should be incorporated into the cost of capital, with the relative importance of a particular source being based on the percentage of the financing provided by each source of capital. Using of the cost a single source of capital, as the hurdle rate is tempting to management, particularly when an investment is financed entirely by debt.  However, doing so is a mistake in logic and can cause problems.

 

Factors determining the cost of capital

 

There are several factors that impact the cost of capital of any company. This would mean that the cost of capital of any two companies would not be equal. Rightly so as these two companies would not carry the same risk.

a.                  General economic conditions: These include the demand for and supply of capital within the economy, and the level of expected inflation. These are reflected in the risk less rate of return and is common to most of the companies.

b.                  Market conditions: The security may not be readily marketable when the investor wants to sell; or even if a continuous demand for the security does exist, the price may vary significantly. This is company specific.

c.                  A firm's operating and financing decisions: Risk also results from the
decisions made within the company. This risk is generally divided into two classes:

1.       Business risk is the variability in returns on assets and is affected by the company's investment decisions.

2.       Financial risk is the increased variability in returns to the common stockholders as a result of using debt and preferred stock.

d.                  Amount of financing required: The last factor determining the company's cost of funds is the amount of financing required, where the cost of capital increases as the financing requirements become larger. This increase may be attributable to one of the two factors:

1.       As increasingly larger public issues are increasingly floated in the market, additional flotation costs (costs of issuing the security) and under pricing will affect the percentage cost of the funds to the firm.

2.       As management approaches the market for large amounts of capital relative to the firm's size, the investors' required rate of return may rise. Suppliers of capital become hesitant to grant relatively large amounts of funds without evidence of management's capability to absorb this capital into the business.

 

Generally, as the level of risk rises, a larger risk premium must be earned to satisfy company's investors. This, when added to the risk-free rate, equals the firm's cost of capital.

 

Assumptions of the cost of capital model

A. Constant business risk

We assume that any investment being considered will not significantly change the firm's business risk. Therefore the overall cost of capital would not change with the changing nature of investments in different markets.

B. Constant financial risk

Management is assumed to use the same financial mix as it used in the past with the same combination of debt and equity.

C. Constant dividend policy

1.                  For ease of computation, it is generally assumed that the firm's dividends are increasing at a constant annual growth rate. Also, this growth is assumed to be a function of the firm's earning capabilities and not merely the result of paying out a larger percentage of the company's earnings.

2.                  We also implicitly assume that the dividend payout ratio (dividend/net income) is constant.

Computing The Weighted Cost Of Capital

 

A firm's weighted cost of capital is a function of (l) the individual costs of capital, (2) the capital structure mix, and (3) the level of financing necessary to make the investment. The individual costs of capital helps in deciding the weigtage that has to be given to the different modes of financing. The capital structure mix decides level of the debt that the company would take up. The level of financing helps in working out the amount that the company could shell out of its own and deciding whether and how much to finance from outside sources.

1.       Determining individual costs of capital

a)       Cost of Debt: As we discussed in the last chapter the before-tax cost of debt is found by trial-and-error by solving for k_d in

                                                PV =  

                   where PV      =        the market price of the debt less flotation costs,

                      Interest      =        the annual interest paid to the investor each year,

                      Principal     =        the maturity value of the debt

                       k_d             =        before-tax cost of the debt (before-tax required rate

                                                of return on debt)

                        n             =        the number of years to maturity.

The after-tax cost of debt equals = k_d(1  -  T).

b)       Cost of preference share (required rate of return on preference share), k_ps, equals the dividend yield based upon the net price (market price less flotation costs) or

                                                k_ps =   =   

c)       Cost of equity share: There are three measurement techniques to obtain the required rate of return on equity shares.

i)        Dividend growth model

          a.       Cost of internally generated common equity, k_s

                             k_s  =    +  

                             k_s  =   

          b)       Cost of new equity share, k_ns

                             k_ns =     

          where NP_o  =   the market price of the equity share less flotation costs incurred in issuing new shares.

ii)       Capital asset pricing model

          As discussed in the last chapter the expected cost of equity share is dependent on the risk profile of the share versus the market as a whole.

                             k_s       =        k_f  +  b(k_m - k_f)

                   where k_s        =        the cost of equity share

                               k_f      =        the risk-free rate

                               b      =        beta, measure of the stock's systematic risk

                               k_m     =        the expected rate of return on the market

          iii) Risk-Premium Approach

All these models are very useful for companies that have their shares listed in the market or about to get them listed. What about the companies that are privately owned. The best way for these companies to do it is to find the general risk premium and take the company specific cost of debt (which is supposed to include the risk premium of the company) and then add the two to find out the equity cost of the company.

                             k_s       =        k_d  +  RP_s

          where k_s       =    cost of equity share

                             k_d       =    cost of debt

                             RP_s      =    risk-premium of equity share

2.       Determining capital structure mix

The individual costs of capital will be different for each source of capital in the firm's capital structure. If the company uses debt to the level of fifty percent of its investment, then the cost of debt should get 50% weightage in the capital structure.

To use the cost of capital in investment analyses, we must compute a weighted or overall cost of capital.

3.       Level of financing and the weighted average cost of capital 

The weighted marginal cost of capital specifies the composite cost for each additional rupee of financing. The firm should continue to invest up to the point where the marginal internal rate of return earned on a new investment (IRR) equals the marginal cost of new capital.

 

Effect of additional financing on the cost of capital would be threefold.

1.                  Issuing new equity share will increase the firm's weighted cost of capital because external equity capital has a higher cost than internally generated common equity. 

2.                  As we use additional debt and preference shares, their cost may increase, which will result in an increase in the weighted cost of capital.

3.                  The increase in the firm's weighted marginal cost of capital curve will occur at the total rupee financing level when all the cheaper funding will be consumed by the firm's investments, given the targeted debt-equity ratio.  The increase in the weighted cost of capital will occur when the total financing from all sources equals:

 

Procedure for determining the weighted marginal cost of capital curve is given below for ready reference.

1.                  Determine financial mix to be used.

2.                  Calculate the level of total financing at which the cost of equity capital increases.

3.                  Calculate the costs of each source of capital.

4.                  Compute the weighted marginal costs of capital at different levels of total financing.

5.                  Construct a graph that compares the internal rates of return of available investment projects with the weighted marginal costs of capital.

 

Calculation of Weighted average cost of capital

 

WACC basic computation is given by the formula given below:

 

          where:

          k_o       =        the weighted average cost of capital

          k_s       =        the cost of equity capital

          k_d       =        the before-tax cost of debt capital

          T        =        the marginal tax rate

          E/(D+E)         =        percentage of financing from equity

          D/(D+E)         =        percentage of financing from debt

          (D+E)  =        Total capital employed by the firm

 

In the formula above we are assuming that the capital has two components only, debt and equity. If the preference capital is also there then it is simply added to it the way other two are denoted.

 

The cost of capital and cash flows are then utilized to evaluate a project by using an evaluation method. These methods are discussed below.